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23 January 2020 / Individuals

How to Calculate Student Loan Interest Deduction

23 January 2020 > Individuals

How to Calculate Student Loan Interest Deduction

If you’re carrying around student loans, you know just how heavy and burdensome they can be. And while debates rage on about topics like student loan forgiveness and the ethics of saddling young people with thousands of dollars in debt, you’re stuck forking over a size-able chunk of your income to Fannie Mae or Freddie Mac.

The good news is that the government wants to help you manage the most frustrating part of your debt: the interest payments. It does so by offering a student loan interest deduction when you file your tax return. In this article, we’ll discuss exactly how to calculate your student loan interest deduction so that you can speed up this painstaking process and move on with your life.

Understanding the Basics of Student Loan Interest

While you probably can’t remember the details anymore – nor did you understand them at the time – you were given a promissory note prior to taking on any student loan debt. This note, which you signed, explained all of the details regarding the loan, interest, repayment, fees, penalties, timelines, etc. 

Interest is the amount of money you pay the lending institution for the privilege of borrowing their money. It’s based on the amount borrowed and is reflected in a percentage point. Whenever you make a payment, it first goes to cover the interest. Once the interest is accounted for, the remaining funds are used to pay down the balance.

As Student Loan Hero explains, “Your interest rate is divided by the number of days in the year to get your ‘interest rate factor.” The interest rate factor is then multiplied by your loan balance and then multiplied by the number of days since your last payment. The result is how much interest you are charged for that period.”

As you make regular payments, your student loan balance gets smaller. Likewise, the amount of interest you owe gets smaller. This accelerates the principal payment. 

Unfortunately, late payments, missed payments, or deferred payments can cause interest to accrue. This means your balance can actually increase over time.

In the early days of paying down student loan debts, the majority of your payment will be interest. Later on, as you near the end of your payments, the reverse is true. The majority of these payments will be premium, with just a small amount going towards interest. This makes the student loan interest deduction especially crucial for young borrowers who are just starting to pay off their student loans.

What is the Student Loan Interest Deduction?

The student loan interest deduction is a federal income tax deduction that lets taxpayers subtract as much as $2,500 in interest paid on qualified student loans from taxable income.

It’s important to note that this is a deduction, not a credit. Like other deductions, it reduces your taxable income. Here’s an example:

If you paid $2,500 in student loan interest over the previous tax year and your income puts you in the 22 percent tax bracket, you would reduce your taxes owed (or increase your tax refund) by $550 (22 percent of $2,500).

One of the biggest perks of the student loan interest deduction is that you don’t have to itemize deductions on a Schedule A in order to claim it. In other words, you can take the standard deduction and still reduce your taxable income by claiming it as an adjustment on IRS Form 1040.

There are, however, restrictions on who can take the deduction. If you’re filing as a single individual, you’re entitled to a full deduction if your modified adjusted gross income (MAGI) is below $65,000. You can get a partial deduction if your MAGI is between $65,000 and $80,000. Anything over $80,000 disqualifies you from claiming the deduction.

For married couples filing jointly, your income must be below $135,000 to qualify for the full deduction and between $135,000 and $165,000 to claim the partial deduction. Anything above $165,000 makes you ineligible. 

How to Calculate Your Student Loan Interest Deduction

If you’ve never run a student loan interest deduction calculation before, it might seem challenging. However, it’s actually a pretty simple formula. 

Let’s say, for example, that you’re a single individual with a modified adjusted gross income of $60,000. You paid $1,500 in student loan interest over the previous year. Because of your income, you qualify for the full deduction. This means you can take the full $1,500 deduction. With an effective tax rate, this means you would essentially reduce your tax bill by $225 ($1,500 x 0.15 percent).

But what happens if you make $75,000? It’s still an easy calculation, but it requires you to calculate a partial deduction instead of a full deduction.

Using this example, you’d take the $1,500 and multiply it by [$75,000-$65,000] / [$80,000-$65,000). This would give you [$1,500] x [$10,000/$15,000]. The resulting number is $1,000. This number represents the amount of interest that’s disallowed. So to get your final number, you’d subtract $1,000 from $1,500 for an allowable deduction of $500. And based on a 20.7 percent effective tax rate, this means your student loan interest deduction is worth roughly $103.50.

Still confused about how to calculate student loan interest deduction? Don’t worry – there are plenty of online calculators that will crunch the numbers for you. This one is simple to use.

Other Education-Related Tax Breaks

The student loan interest deduction is just one tax break for higher education. If you’re still a student, you may be eligible for other deductions and credits. They include:

  • American Opportunity Tax Credit.

    The AOTC covers qualified education expenses for students over the first four years of post-secondary education. It also applies to taxpayers who claim students as dependents. The maximum tax credit is $2,500. However, this is one of the few deductions that is refundable. This means that even if your tax liability is reduced to zero with the AOTC, you can still receive 40 percent of the remaining credit (up to $1,000).

  • Lifetime Learning Credit.

    This credit lets parents and students reduce their tax liability by as much as $2,000. The credit works in the form of a match, which means the IRS matches parents/students dollar for dollar on qualified educational expenses up to the limit. In order to qualify, there are income limitations. Taxpayers filing individually can’t have a MAGI over $66,000. Taxpayers filing jointly must have an income below $132,000.

  • 529 College Savings Plans.

    A 529 plan is a tax-advantaged savings account that’s designed to help taxpayers pay for education. It was originally reserved for post-secondary education expenses, but has recently been expanded to cover K-12 education. Every state has its own rules regarding 529 plans, but they’re generally funded using post-tax income. The funds then grow tax-free. There are also no taxes upon withdrawal. In some states, you can deduct contributions from your state income taxes. 

While education can be expensive, the government wants to incentivize taxpayers to be lifelong learners and to invest in formal education. The more you leverage these tax breaks, the more you’ll save. 

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Ralph Carnicer

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